Startup mentors discuss strategies and challenges of creating a new business.

Part I: In Through the Out Door

ED ZIMMERMAN:Understanding what will happen next year requires a look at the way the dynamics of the venture market have shifted in the last decade.

Six years ago, VCs complained that founders were aiming low and taking early exits. Investors bemoaned the increasingly routine occurrence of a $50 million sale of a startup because they wanted the founders to hold on until the IPO.

Here’s what happened in response:

Emergence of Seed Investors. Many of these founders who sold early began angel-investing from the small but meaningful pool of capital that their early exits yielded. Simultaneously, VCs realized that these small exits created an opportunity — funds could profitably invest small dollars in many seed stage start-ups, even if most of them sold early.

Interim Liquidity. To proactively thwart early offers to sell the company, VCs began offering founders “partial-liquidity” (founders could sell some but not all of their personal holdings to VCs for cash). This trend was new in venture.

The Growth of Growth Stage. Later-stage funds emerged to pick from among the winners and apply “momentum investing” to venture. These funds raised large pools of capital and provided partial liquidity and growth dollars to enable companies to hold on even longer. Growing companies needed to hold on longer because there weren’t as many buyers at $300 million and up, and because the path to IPO had lengthened due to the passage of the Sarbanes-Oxley Act. Also, in case you missed it, the stock market was lousy.

What followed? While early exits continued, more founders did hold on. Some held on long enough to build massive companies like Facebook and Twitter — answering the dreams and hopes of the venture community. Others held on so long their companies crested, and investors now wish they had sold way earlier.

I think this dynamic informs the startup community in 2013. Here’s why: those seed funds that have ‘sprayed and prayed’ have, by design, each invested in scores of companies, but so have the funds up the chain. Unlike mutual fund managers, who are often hands-off investors, venture investors are expected — indeed, obligated — to add value to their portfolio companies. If they don’t, they suffer reputational damage and are less likely, over time, to be in the flow of deals. Consequently, once a VC has too many portfolio companies, she or he can’t pay attention to all of them — the investors run short of bandwidth. That’s where we now find ourselves.

So, in 2013, investors will strive to harvest more of their investments (a) to help the fund itself with fundraising (pension funds, university endowments and others who provide capital to the funds will want to see returns in order to justify investing in a given VC’s next fund), (b) to clean out their portfolio and make room or time for new companies, and (c) because they’ve seen valuations dip in some sectors (daily deals, for instance) and don’t feel like holding those stocks for more than another year. Why don’t they want to hold them? Well, many of those companies haven’t yet hit profitability and that means they will need to raise more capital, which will dilute the current investors and make it harder to reap huge returns. Here is how that math works:

If you take a venture round at a valuation of $10 million and sell for $100 million, there will be a very healthy increase in the stock price. But what if you take a venture round at $125 million value and sell for $200 million? That is a big sale price in the context of historical outcomes in venture capital, yet the last investors won’t even double their money. Taking later-stage venture capital means, to an extent, committing to a very large exit. While venture investors want founders to build very big businesses, they also want to have some easier wins, especially because they believe very few companies will defy valuation-gravity enough to sell for more than $500 million.

“I don’t believe that there’s going to be a fundamental shift in how VCs play their exits in 2013. Venture requires patience…and many of these categories are still maturing. Across many of the categories, many new bets were placed in 2012. I don’t believe the investors placing them were expecting 2013 exits,” Parekh said.

Sounds like he expects to continue deploying capital at about the same pace and while he conceded that there might be an uptick in exits at the margins, he thinks next year’s startup market looks quite a bit like this year’s. I guess we’ll see.

About The Accelerators

For aspiring or actual entrepreneurs, The Accelerators is an online archive of discussion among startup mentors– entrepreneurs, angel investors and venture capitalists. Although the blog is no longer being updated, its content lives here and you can see an archive of its tweets through June 2015 @wsjstartup.